SOUTHERN FIRST BANCSHARES INC - Quarter Report: 2007 September (Form 10-Q)

SOUTHERN FIRST BANCSHARES, INC.
PART I.  FINANCIAL INFORMATION

             Item 1.  Financial Statements

             The financial statements of Southern First Bancshares, Inc. and Subsidiary are set forth in the following pages.

SOUTHERN  FIRST BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements that are an integral part of these consolidated statements.

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME

 See notes to consolidated financial statements that are an integral part of these consolidated statements.

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME 

See notes to consolidated financial statements that are an integral part of these consolidated statements.

SOUTHERN  FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
AND COMPREHENSIVE INCOME
FOR THE NINE MONTHS ENDED SEPTEMBER  30, 2007  AND 2006
(Unaudited)

SOUTHERN FIRST BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS

 See notes to consolidated financial statements that are an integral part of these consolidated statements.

SOUTHERN FIRST BANCSHARES, INC.  AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 - Nature of Business and Basis of Presentation

Business activity

             Southern First Bancshares, Inc. is a South Carolina corporation that owns all of the capital stock of Southern First Bank, N.A. and all of the stock of Greenville First Statutory Trust I and Trust II (collectively the "Trusts").  On July 2, 2007, the holding company changed its name from Greenville First Bancshares, Inc. to Southern First Bancshares, Inc. and the bank changed its name from Greenville First Bank, N.A. to Southern First Bank, N.A.  The bank will however, continue to operate under the trade name, Greenville First Bank, in Greenville County.   The bank is a national bank organized under the laws of the United States located in Greenville and Richland Counties, South Carolina. The bank is primarily engaged in the business of accepting demand deposits and savings deposits insured by the Federal Deposit Insurance Corporation, and providing commercial, consumer and mortgage loans to the general public.  The bank owns all of the capital stock of JB Properties.  This subsidiary is used for the purpose of owning real estate acquired in loan foreclosures.   The Trusts are special purpose subsidiaries for the sole purpose of issuing trust preferred securities.

Basis of Presentation

             The accompanying financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q.  Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three and nine month periods ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.  For further information, refer to the consolidated financial statements and footnotes thereto included in the company's Form 10-K for the year ended December 31, 2006 (Registration Number 000-27719) as filed with the Securities and Exchange Commission.  The consolidated financial statements include the accounts of Southern First Bancshares, Inc., and its wholly owned subsidiary Southern First Bank, N.A.  In accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 46, the financial statements related to the special purpose subsidiaries, Greenville First Statutory Trust I and Trust II have not been consolidated.

Cash and Cash Equivalents

             For purposes of the Consolidated Statements of Cash Flows, cash and federal funds sold are included in "cash and cash equivalents."  These assets have contractual maturities of less than three months.

Note 2 - Property Held for Sale

            In February 2007, we decided to actively market the sale of our former main office and corporate headquarters building.  Accordingly, we reclassified the building from property and equipment to property held for sale, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 144 "Accounting for the Impairment and Disposal of Long-Lived Assets," and ceased depreciation of the building.  On April 13, 2007, we completed the sale of the former main office building.  Based on the sales contract, adjusted for commissions and other selling costs, we recorded a $319,291 gain on the sale of the building during the nine months ended September 30, 2007.  The $319,291 gain was partially offset by other unrelated real estate operating expenses of $140,036.  The net gain on real estate operations recorded in the nine months ended September 30, 2007 was $210,165.

Note 3 - Note Payable

The company has an unused $4.5 million revolving line of credit with another bank that matures on March 20, 2008.  The line of credit bears interest at a rate of three-month libor plus 2.00%, which at September 30, 2007 was 7.23%.  The company has pledged the stock of the bank as collateral for this line of credit.  The line of credit agreement contains various covenants related to net income and asset quality.  As of September 30, 2007, the company believes it is in compliance with all covenants.

Note 4 - Earnings per Share

             The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share computations for the three and nine months ended September 30, 2007 and 2006.  Dilutive common shares arise from the potentially dilutive effect of the company's stock options and warrants that are outstanding.  The assumed conversion of stock options and warrants can create a difference between basic and dilutive net income per common share. 

             At September 30, 2007, 13,000 options were anti-dilutive in the calculation of earnings per share as their exercise price exceeded the fair market value.

 Note 5 - Stock Based Compensation

             The company has a stock-based employee compensation plan.  On January 1, 2006, the company adopted the fair value recognition provisions of SFAS No. 123(R), "Accounting for Stock-Based Compensation," to account for compensation costs under its stock option plan.  On December 20, 2005, the Board of Directors approved accelerating the vesting of 45,813 unvested stock options effective December 28, 2005.  The decision to accelerate vesting of these options resulted in a reduction of compensation expense by approximately $68,000 for the year ended December 31, 2006 and will result in a reduction of compensation expense by approximately $52,000, $4,000, and $4,000 for the years ended December 31, 2007, 2008, and  2009, respectively.

In adopting SFAS No. 123(R), the company elected to use the modified prospective method to account for the transition from the intrinsic value method to the fair value recognition method.  Under the modified prospective method, compensation cost is recognized from the adoption date forward for all new stock options granted and for any outstanding unvested awards as if the fair value method had been applied to those awards as of the date of grant.    

The fair value of the option grant is estimated on the date of grant using the Black-Scholes option-pricing model.  The following assumptions were used for grants: expected volatility of 6.76% for 2007 and 2006, risk-free interest rate of 4.60% for 2007 and 4.02% for 2006, expected lives of the options is 10 years, and the assumed dividend rate was zero. 

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion reviews our results of operations and assesses our financial condition.  You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements.  The commentary should be read in conjunction with the discussion of forward-looking statements, the financial statements and the related notes and the other statistical information included in this report.

DISCUSSION OF FORWARD-LOOKING STATEMENTS

                This report contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are based on many assumptions and estimates and are not guarantees of future performance.  Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control.  The words "may,"  "would," "could," "will," "expect," "anticipate," "believe," "intend," "plan," and "estimate," as well as similar expressions, are meant to identify such forward-looking statements.  Potential risks and uncertainties that could cause our actual results to differ from those anticipated in any forward-looking statements include, but are not limited to, those described in our Form 10-K for the year ended December 31, 2006 under Item 1A- Risk Factors and the following:

•         significant increases in competitive pressure in the banking and financial services industries;

•         changes in the interest rate environment which could reduce anticipated or actual margins;

•         changes in political conditions or the legislative or regulatory environment;

•         general economic conditions, either nationally or regionally and especially in our primary service area, becoming less favorable than expected resulting in, among other things, a  deterioration in credit quality;

•         changes occurring in business conditions and inflation;

•         changes in technology;

•         changes in deposit flows,

•         changes in monetary and tax policies;

•         the level of allowance for loan loss;

•         the rate of delinquencies and amounts of charge-offs;

•         the rates of loan growth and the lack of seasoning of our loan portfolio;

•         adverse changes in asset quality and resulting credit risk-related losses and expenses;

•         loss of consumer confidence and economic disruptions resulting from terrorist activities;

•         changes in the securities markets; and

•         other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

                We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

Overview 

We were incorporated in March 1999 to organize and serve as the holding company for Greenville First Bank, N.A.  On July 2, 2007, we changed our name to Southern First Bancshares, Inc. and the bank's name to Southern First Bank, N.A., although we will continue to operate as Greenville First Bank in Greenville County.  Our primary reason for the name change was related to our expansion into the Columbia, SC market.  Since we opened our bank in January 2000, we have experienced consistent growth in total assets, loans, deposits, and shareholders' equity, which has continued during the first nine months of 2007. 

Like most community banks, we derive the majority of our income from interest received on our loans and investments.  Our primary source of funds for making these loans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings.  Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities, which is called our net interest spread. 

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible.  We maintain this allowance by charging a provision for loan losses against our operating earnings for each period.  We have included a detailed discussion of this process, as well as several tables describing our allowance for loan losses.

In addition to earning interest on our loans and investments, we earn income through fees and other charges to our customers.  We have also included a discussion of the various components of this noninterest income, as well as of our noninterest expense.

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements.  We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in our filings with the Securities and Exchange Commission.

Critical Accounting Policies

                We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States and with general practices within the banking industry in the preparation of our financial statements.  Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2006, as filed in our annual report on Form 10-K.

                Certain accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of certain assets and liabilities.  We consider these accounting policies to be critical accounting policies.  The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements.  Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses.  Under different conditions, the actual amount of credit losses incurred by us may be different from management's estimates provided in our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

 Effect of Economic Trends

                 Following an economic decline and historically low interest rates that ended in the first six months of 2004, the Federal Reserve began increasing short-term rates as the economy showed signs of strengthening.  Between July 2004 and July 2006, the Federal Reserve increased rates at 17 of their meetings for a total of 425 basis points. Between July 2006 and September 18, 2007, the Federal Reserve allowed short-term rates to remain unchanged, leading many economists to believe that the Federal Reserve was nearing the end of this cycle of rate increases.   Consequently, beginning in July 2004 and continuing until September 18, 2007, our rates on both short-term or variable rate interest-earning assets and interest-bearing liabilities have increased.  The momentum of the 17 rate increases resulted in higher rates on interest-earning assets and higher interest-bearing liabilities during the first nine months of 2007; subsequently, as fixed rate loans, deposits, and borrowings have matured they have repriced at higher interest rates.  On September 18, 2007, the Federal Reserve reversed their position and lowered the short-term rates by 50 basis points, leading many economists to believe that the Federal Reserve may begin a cycle of  rate decreases. The results of the Federal Reserve's actions on September 18, 2007 resulted in a decline of rates on our variable rate loans, investments, deposits and borrowings.  The following discussion includes our analysis of the effect that we anticipate changes in interest rates will have on our financial condition.  However, we can give no assurances as to the future actions of the Federal Reserve or to the anticipated results that will actually occur.

Results of Operations

Income Statement Review

Summary

Three months ended September30, 2007 and 2006

                Our net income was $956,562 and $1.0 million for the three months ended September 30, 2007 and 2006, respectively, a decrease of $63,115, or 6.2%.  The $63,115 decrease in net income resulted primarily from an increase of $931,160 in noninterest expenses and an additional $50,000 in the provision for loan losses, partially offset by increases of $729,417 in net interest income and $134,518 in noninterest income.   Our efficiency ratio increased due to higher operating costs related to additional infrastructure in Greenville County, our expansion into the Columbia, SC market, and a lower net margin.  Our efficiency ratio was 59.6% and 48.7% for the three months ended September 30, 2007 and 2006, respectively.  We believe that our efficiency ratio will improve in future periods as earning assets are anticipated to increase at a higher rate than noninterest expenses due to our recent investment in infrastructure.  However, we can give no assurances that we will be able to achieve this goal.

Nine months ended September 30, 2007 and 2006

                Our net income was $2.7 million and $2.8 million for the nine months ended September 30, 2007 and 2006, respectively, a decrease of $165,784, or 5.9%.  The decrease in net income resulted primarily from increases of $2.7 million in noninterest expenses and $90,000 in the provision for loan losses, partially offset by increases of $1.7 million in net interest income and $586,488 in noninterest income.  Our efficiency ratio was 60.8% and 49.1% for the nine months ended September 30, 2007 and 2006, respectively.  We believe that our efficiency ratio will improve in future periods as earning assets are anticipated to increase at a higher rate than noninterest expenses due to our recent investment in infrastructure.  However, we can give no assurances that we will be able to achieve this goal.

             Net Interest Income

                Our level of net interest income is determined by the level of earning assets and the management of our net interest margin.  The continuous growth in our loan portfolio is the primary driver of the increase in net interest income.  During the nine months ended September 30, 2007, our average loan portfolio increased $76.4 million compared to the average for the nine months ended September 30, 2006.  The actual growth in the first nine months of 2007 was $81.0 million.  We anticipate the growth in loans will continue to drive the growth in assets and the growth in net interest income.  However, we can give no assurances that we will be able to continue to increase loans at the same levels we have experienced in the past.

Our decision to grow the loan portfolio at the current pace created the need for a higher level of capital and the need to increase deposits and borrowings.  This loan growth strategy also resulted in a significant portion of our assets being in higher earning loans than in lower yielding investments.  At September 30, 2007, net loans represented 77.9% of total assets.  However, as described below, we have also increased our level of deposits significantly.  While we plan to continue our focus on increasing the loan portfolio, as rates on investment securities rose during the past twelve months and we obtained additional deposits, we increased the size of the investment portfolio.  Consequently,  net loans as a percentage of total assets remained at 77.9%.  Our investment portfolio increased by $14.9 million from September 30, 2006 to September 30, 2007.  At September 30, 2007, investments and federal funds sold represented 17.4% of total assets. 

The historically low interest rate environment that was experienced between January of 2000 and July of 2004, allowed us to obtain short-term borrowings and wholesale certificates of deposit at rates that were lower than certificate of deposit rates being offered in our local market.  Therefore, we decided not to begin our retail deposit office expansion program until the beginning of 2005.  This funding strategy allowed us to continue to operate in one location until 2005, maintain a smaller staff, and not incur marketing costs to advertise deposit rates, which in turn allowed us to focus on the fast growing loan portfolio. 

We opened two retail deposit offices in 2005.  During the third quarter of 2007, we converted our Columbia loan production office into a full service branch facility.  Our focus for these three locations is to obtain low cost transaction accounts.  Our goal is to increase both the percentage of assets being funded by "in market" retail deposits and to increase the percentage of low-cost transaction accounts to total deposits.  We anticipate opening two additional retail deposit offices during the first six months of 2008, one in the Columbia market and one in the Greenville market.  These offices will assist us in meeting the previously stated objectives.  We believe that this growth strategy will provide us with additional clients in our two market areas and will eventually provide a lower alternative cost of funding.   At September 30, 2007, retail deposits represented $269.6 million, or 43.9% of total assets, borrowings represented $156.9 million, or 25.5% of total assets, and wholesale out-of-market deposits represented $145.4 million, or 23.7% of total assets.

Our net interest income margin for the nine months ended September 30, 2007 exceeded our net interest spread because we had more interest-earning assets than interest-bearing liabilities.  Average interest-earning assets exceeded average interest-bearing liabilities by $48.7 million and $45.4 million for the nine months ended September 30, 2007 and 2006, respectively. 

In addition to the growth in both assets and liabilities, and the ratio of interest-earning assets to interest-bearing liabilities, net interest income is also affected by the timing of the repricing of our assets and liabilities, and the changes in interest rates earned on our assets and interest rates paid on our liabilities. Until September 18, 2007, our yields on interest earning assets and the rates that we paid for our deposits and borrowings continued to increase primarily as a result of the actions taken by the Federal Reserve prior to July 30, 2006 to raise short-term rates.   Our fixed rate loans are being originated or renewed at higher rates, while the rates on new or maturing interest-bearing liabilities are also higher than in the past.  Our net interest spread declined since more of our rate-sensitive liabilities repriced than our rate-sensitive assets during the twelve month period ended September 30, 2007.  Given the fact that the Federal Reserve increased short-term rates by 425 basis points between July 2004 and July 2006 and allowed rates to remain unchanged until September 18, 2007, we believed during most of 2006 and the first nine months of 2007 that short-term interest rates were at or near their peak.  Therefore, we chose to increase the amount of fixed rate loans in our loan portfolio and targeted to have a significant portion of our liabilities to reprice within a twelve month period.  On September 18, 2007, the Federal Reserve decided to decrease the short-term rates by 50 basis points.  While the bank had more assets that repriced down on September 18, 2007, the amount of liabilities that will reprice over the next three months will "neutralize" the immediate downward negative impact and then we believe we will begin to have a positive impact on our net interest income for the nine months thereafter.

As more fully discussed in the - "Market Risk" and - "Liquidity and Interest Rate Sensitivity" sections below, at September 30, 2007, 60% of our loans had fixed rates.  During 2006 and the first nine months of 2007, we have placed more emphasis on fixed rate loans.  During this period, our fixed rates loans as a percentage of total loans increased from 39% to 60%.  While our percentage of fixed rate loans has increased, our focus during the past three years has been to obtain short-term liabilities to fund our asset growth.  This strategy has resulted in our ability to move from being asset sensitive to being liability sensitive.  We are currently positioned to benefit from lower market rates and to be negatively impacted by higher market rates.

At September 30, 2007, 89.0% of our interest-bearing liabilities were either variable rate or had a maturity of less than one year.   Therefore, we believe that we are positioned to benefit from future decreases in short-term rates.  Conversely, future increases in short-term rates would likely have a negative effect on our earnings.  At September 30, 2007, we had $200.1 million more liabilities than assets that reprice within the next twelve months.  Based on a review of our deposit portfolio, we believe that the interest rates that we pay on the majority of our interest-bearing transaction accounts would only be impacted by a portion of any change in market rates.  This key assumption is utilized in our overall evaluation of our level of interest sensitivity.

We have included a number of tables to assist in our description of various measures of our financial performance.  For example, the "Average Balances" tables shows the average balance of each category of our assets and liabilities as well as the yield we earned or the rate we paid with respect to each category during the three month periods ended September 30, 2007 and 2006.  A review of these tables shows that our loans typically provide higher interest yields than do other types of interest-earning assets, which is why we direct a substantial percentage of our earning assets into our loan portfolio.  Similarly, the "Rate/Volume Analysis" table demonstrates the effect of changing interest rates and changing volume of assets and liabilities on our financial condition during the periods shown.  A review of these tables shows that as short-term rates continued to rise, the increase in net interest income is more effected by the changes in rates than in prior years.  We also track the sensitivity of our various categories of assets and liabilities to changes in interest rates, and we have included tables to illustrate our interest rate sensitivity with respect to interest-earning accounts and interest-bearing accounts.  Finally, we have included various tables that provide detail about our investment securities, our loans, our deposits, and other borrowings.

The following tables set forth information related to our average balance sheets, average yields on assets, and average costs of liabilities.  We derived these yields by dividing income or expense by the average balance of the corresponding assets or liabilities.  We derived average balances from the daily balances throughout the periods indicated.  During the three month and nine month periods ended September 30, 2007 and 2006, we had no interest-bearing deposits in other banks or any securities purchased with agreements to resell.  All investments owned have an original maturity of over one year.  Nonaccrual loans are included in the following tables.  Loan yields have been reduced to reflect the negative impact on our earnings of loans on nonaccrual status.  The net of capitalized loan costs and fees are amortized into interest income on loans.

Our net interest spread, on a tax-equivalent basis, was 2.74% for the three months ended September 30, 2007 compared to 2.82% for the three months ended September 30, 2006.  The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities.

The 8 basis point reduction in our net interest spread resulted primarily from the lower spread on the $108.3 million growth in average earning assets in the third quarter of 2007 compared to the same period in 2006.  The additional earning assets and liabilities yielded a lower than historical net spread of 2.15%, accounting for a 14 basis point reduction in the net interest spread.  The 14 basis point decline was partially offset by a 6 basis point increase related to the remaining assets repricing at a higher rate then the related liabilities.

During 2006 and the first nine months of 2007, management determined that the bank had excess capital.  Consequently, given the flat interest rate environment, both earnings and return on equity could be increased with additional assets and liabilities even if the net interest spreads were at less than historical levels.  Accordingly, $19.1 million or 17.6% of the total growth in earning assets occurred in investments and federal funds, yielding a combined weighted rate of 5.40% for the third quarter of 2007.  The remaining growth in earning assets of $89.2 million, or 82.4% of the total growth, occurred in loans which yielded a weighted rate of 7.63% in the third quarter of 2007.  This combination of investments, federal funds, and loans yielded a weighted rate of 7.24%.

The growth of $108.3 million in earning assets was funded primarily with $38.0 million in borrowings with a weighted rate of 4.88% and $65.1 million in certificates of deposit with a weighted rate of 5.17%.  Since the total growth in earning assets was funded with higher borrowing and certificate of deposit rates, the combined funding cost was 5.09%.

Although, substantially all of the variable rate assets and the short-term and variable rate liabilities have repriced to market rates, our net interest spread may continue to decline in future periods, should a substantial portion of growth in earning assets continue to be funded with higher rate borrowings and certificates of deposit.

Our net interest margin is calculated as net interest income divided by average interest-earning assets.  Our net interest margin, on a tax-equivalent basis, for the three months ended September 30, 2007 was 3.15% compared to 3.25% for the three months ended September 30, 2006.  During the three months ended September 30, 2007, interest-earning assets exceeded interest-bearing liabilities by $51.1 million compared to $44.4 million for the three month period ended September 30, 2006.  The primary reasons for the $6.7 million increase in interest-earnings assets exceeding interest- bearing liabilities relates to the $2.4 million proceeds from the sale of real estate and the earnings accumulated between the second and third quarters of 2007.

Our loan yield increased 12 basis points for the three months ended September 30, 2007 compared to the three months ended September 30, 2006 as a result of loans maturing or being renewed at market rates higher than their original rates and the impact of higher market rates on our variable rate loans which represent approximately 40% of the loan portfolio at September 30, 2007.  Offsetting the increase in our loan yield was a 32 basis point increase in the cost of our interest-bearing deposits for the third quarter of 2007 compared to the same period in 2006.  The increase in the rate on interest-bearing deposits is due to the renewal rates on time deposits also being much higher than those in the past combined with our lower costing transaction accounts which now represent a smaller percentage of our total interest-bearing deposits.  The cost of our FHLB advances increased 18 basis points while other borrowings increased 20 basis points.  As of September 30, 2007, approximately 49% of our FHLB advances had variable rates, while all of our other borrowings had variable rates.

Net interest income, the largest component of our income, was $4.4 million and $3.7 million for the three months ended September 30, 2007 and 2006, respectively.  The increase in the third quarter of 2007 related primarily to the net effect of higher levels of both average interest-earning assets and interest-bearing liabilities.  Average interest-earning assets were $108.3 million higher during the three months ended September 30, 2007 compared to the same period in 2006.  During the same period, average interest-bearing liabilities increased $101.6 million.  The higher average balances resulted in $1.2 million additional net interest income for the three months ended September 30, 2007, while lower spreads on the average balances reduced net interest income by $406,000.

Interest income for the three months ended September 30, 2007 was $10.3 million, consisting of $9.1 million on loans, $1.1 million on investments, and $77,278 on federal funds sold.  Interest income for the three months ended September 30, 2006 was $8.1 million, consisting of $7.3 million on loans, $766,990 on investments, and $100,211 on federal funds sold.  Interest on loans for the three months ended September 30, 2007 and 2006 represented 88.5% and 89.3%, respectively, of total interest income, while income from investments and federal funds sold represented only 11.5% and 10.7%, respectively, of total interest income.  The high percentage of interest income from loans relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments.  Average loans represented 84.6% and 85.1% of average interest-earning assets for the three months ended September 30, 2007 and 2006, respectively.  Included in interest income on loans for the three months ended September 30, 2007 and 2006 was $178,810 and $124,731, respectively, which related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the three months ended September 30, 2007 was $5.9 million, consisting of $4.0 million related to deposits and $1.8 million related to FHLB advances and other borrowings.  Interest expense for the three months ended September 30, 2006 was $4.4 million, consisting of $3.1 million related to deposits and $1.4 million related to FHLB advances and other borrowings.  Interest expense on deposits for the three months ended September 30, 2007 and 2006 represented 68.5% and 69.1%, respectively, of total interest expense, while interest expense on FHLB advances and other borrowings represented 31.5% and 30.9%, respectively, of total interest expense for the same three month periods.  For the three months ended September 30, 2007, average interest-bearing deposits increased by $63.6 million over the same period in 2006, while FHLB advances increased $41.2 million and other borrowings decreased $3.2 million during the three months ended September 30, 2007 over the same period in 2006.  Both the short-term borrowings from the FHLB advances and the sale of securities under agreements to repurchase provide us with the opportunity to obtain low cost funding with various maturities similar to the maturities on our loans and investments. 

Our net interest spread was 2.67% for the nine months ended September 30, 2007, compared to 2.91% for the nine months ended September 30, 2006.  The net interest spread is the difference between the yield we earn on our interest-earning assets and the rate we pay on our interest-bearing liabilities. 

The 24 basis point reduction in our net interest spread resulted primarily from the lower spreads on our $113.3 million growth in average earning assets in the first nine months of 2007 compared to the same period in 2006.  The additional earning assets and liabilities yielded a lower than historical net spread of 1.97%, which caused the overall net interest spread to decline by 23 basis points.  The remaining one basis point reduction in net interest spread resulted from the impact of liabilities repricing over a longer period than the related assets that repriced.  Therefore, once short-term market rates stopped increasing, certain short-term liabilities such as one year certificates of deposit continued to slowly reprice to the current market rates as they matured.  Management believes that substantially all of our variable rate assets and short-term liabilities have been repriced to current market rates as of September 30, 2007.  

During 2006 and the first nine months of 2007, management determined that the bank had excess capital.  Consequently, given the flat interest rate environment, both earnings and return on equity could be increased with additional assets and liabilities even if the net interest spreads were at less than historical levels.  Accordingly, $37.0 million or 32.6% of the total growth in earning assets occurred in investments and federal funds, yielding a combined weighted rate of 5.44% for the first nine months of 2007.  The remaining growth in earning assets of $76.4 million, or 67.4% of the total growth, occurred in loans which yielded a weighted rate of 7.59% in the first nine months of 2007.  This combination of investments, federal funds, and loans yielded a weighted rate of 6.89%.

The growth of $113.3 million in earning assets was funded primarily with $28.5 million in borrowings with a weighted rate of 4.85% and $74.4 million in certificates of deposit with a weighted rate of 5.17% for the nine months ended September 30, 2007.  Since the total growth in earning assets was funded with higher borrowing and certificate of deposit rates, the combined funding cost was 4.92%.

Although, substantially all of the variable rate assets and the short-term and variable rate liabilities have repriced to market rates, our net interest spread may continue to decline in future periods, should a substantial portion of growth in earning assets continue to be funded with higher rate borrowings and certificates of deposit.

Our net interest margin is calculated as net interest income divided by average interest-earning assets.  Our net interest margin, on a tax-equivalent basis, for the nine months ended September 30, 2007 was 3.09%, compared to 3.35% for the nine months ended September 30, 2006.  During the nine months ended September 30, 2007, interest-earning assets averaged $537.4 million, compared to $424.1 million in the nine months ended September 30, 2006.  Interest earning assets exceeded interest bearing liabilities by $48.7 million and $45.4 million for the nine month periods ended September 30, 2007 and 2006, respectively. 

Our loan yield increased 28 basis points for the nine months ended September 30, 2007 compared to the nine months ended September 30, 2006.  This increase is as a result of loans maturing or being renewed at rates higher than their original rates as well as the impact of higher market rates on our variable rate loans which represent approximately 40% of the loan portfolio at September 30, 2007.  Offsetting the increase in our loan yield is a 57 basis point increase in the cost of our interest-bearing deposits for the first nine months of 2007 compared to the same period in 2006.  The increase in the rate on our time deposits is also due to the renewal rates on time deposits being much higher than those in the past.   In addition, the cost of our savings and money market accounts has increased by 18 basis points as we have increased the rates we offer on these products to stay competitive in response to the increase in short-term market rates.  The 32 basis point increase in FHLB advances and the 78 basis point increase in other borrowed funds in the first nine months of 2007 compared to the same period in 2006 resulted primarily from the repricing of matured FHLB advances to higher market rates and carrying a lower balance of other borrowings at higher rates.  As of September 30, 2007, approximately 49% of our FHLB advances had variable rates, while all of our other borrowings had variable rates.

Net interest income, the largest component of our income, was $12.4 million and $10.6 million for the nine months ended September 30, 2007 and 2006, respectively.  Of the $1.8 million increase in net interest income, approximately $2.5 million related to the impact of higher average earning assets and interest-bearing liabilities in the nine months ended September 30, 2007 compared to the same period in 2006, while lower spreads on the average balances reduced net interest income by $573,000.

Average earning assets were $113.3 million higher during the nine months ended September 30, 2007 compared to the same period in 2006, and average interest-bearing liabilities increased by $110.0 million during the same period, while lower spreads on the average balances reduced net interest income by $573,000.

Interest income for the nine months ended September 30, 2007 was $29.0 million, consisting of $25.3 million on loans, $3.2 million on investments, and $441,126 on federal funds sold.  Interest income for the nine months ended September 30, 2006 was $22.3 million, consisting of $20.2 million on loans, $1.9 million on investments, and $192,007 on federal funds sold.  Interest on loans for the nine months ended September 30, 2007 and 2006 represented 87.3% and 90.8%, respectively, of total interest income, while income from investments and federal funds sold represented only 12.7% and 9.2% of total interest income.  The high percentage of interest income from loans relates to our strategy to maintain a significant portion of our assets in higher earning loans compared to lower yielding investments.  Average loans represented 83.0% and 87.1% of average interest-earning assets for the nine months ended September 30, 2007 and 2006, respectively.  Included in interest income on loans for the nine months ended September 30, 2007 and 2006, was $524,720 and $402,167, respectively, related to the net amortization of loan fees and capitalized loan origination costs.

Interest expense for the nine months ended September 30, 2007 was $16.6 million, consisting of $11.5 million related to deposits and $5.1 million related to borrowings.  Interest expense for the nine months ended September 30, 2006 was $11.6 million, consisting of $7.7 million related to deposits and $3.9 million related to borrowings.  Interest expense on deposits for the nine months ended September 30, 2007 and 2006 represented 69.4% and 66.1%, respectively, of total interest expense, while interest expense on borrowings represented 30.6% and 33.9%, respectively, of total interest expense for the same periods.  During the nine months ended September 30, 2007, average interest-bearing deposits increased by $81.5 million, while FHLB and other borrowings increased $28.5 million compared to the same period in 2006.  During the nine months ended September 30, 2007, we pledged additional collateral to the FHLB, allowing us to increase our FHLB borrowings.  Both the short-term borrowings from the FHLB and the sale of securities under agreements to repurchase provide us with the opportunity to obtain low cost funding with various maturities similar to the maturities on our loans and investments.

Rate/Volume Analysis 

Net interest income can be analyzed in terms of the impact of changing interest rates and changing volume.  The following tables set forth the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the periods presented.

Provision for Loan Losses

             We have established an allowance for loan losses through a provision for loan losses charged as an expense on our statement of income.  We review our loan portfolio periodically to evaluate our outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses.  Please see the discussion below under "Balance Sheet Review - Provision and Allowance for Loan Losses" for a description of the factors we consider in determining the amount of the provision we expense each period to maintain this allowance.

Three and nine months ended September 30, 2007 and 2006

For the three months ended September 30, 2007 and 2006, we incurred a noncash expense related to the provision for loan losses of $450,000 and $400,000, respectively, bringing the allowance for loan losses to $5.4 million and $4.6 million, respectively.  The allowance represented 1.13% of gross loans at September 30, 2007 and 1.18% of gross loans at September 30, 2006.  During the three months ended September 30, 2007, we charged-off $296,994 of loans and recorded $817 of recoveries on loans previously charged-off.  During the three months ended September 30, 2006, we charged off $49,472 of loans and recorded $36,197 of recoveries on loans previously charged-off.  The $296,177 and $13,275 net charge-offs during the third quarters of 2007 and 2006, respectively, represented an annualized rate of .25% and less than one basis point of the average outstanding loan portfolio for the three months ended September 30, 2007 and 2006, respectively.

For the nine months ended September 30, 2007, we incurred a noncash expense related to the provision for loan losses of $1.3 million, bringing the allowance for loan losses to $5.4 million, or 1.13% of gross loans, as of September 30, 2007.  The $1.3 million provision for the nine months ended September 30, 2007 related primarily to the level of charge-offs that occurred during this period.   During the nine month period ended September 30, 2007, we charged-off $823,199 in loans and recorded $31,380 of recoveries on loans previously charged-off.  In contrast, for the nine months ended September 30, 2006, we added $1.2 million to the provision for loan losses, resulting in an allowance of $4.6 million at September 30, 2006. During the nine months ended September 30, 2006, we charged-off $1.2 million of loans and recorded $119,152 of recoveries on loans previously charged-off.

At September 30, 2007, the allowance for loan losses represented 1.8 times the amount of non-performing loans.  As a result of this level of coverage on non-performing loans and our internal loan calculation, we determined that the provisions of $450,000 and $1.3 million for the three and nine months ended September 30, 2007 were adequate.

Noninterest Income

             The following table sets forth information related to our noninterest income.